How To Fix The British Economy

In MoneyWeek this week, I've been writing about how to fix the British economy. Here's a taster.

A banking system so bankrupt, half of it has had to be taken into state control. A regulatory system exposed as a shambles. Monetary policy in a state of confusion. And public finances shot to pieces.
Take all those together, and there can be little debate that the system Gordon Brown, and his main intellectual adviser Ed Balls, laid down for running the British economy in 1997 have been shot to pieces. If it was a house, it would have been condemned.
Now, the first signs of a debate about how to formulate a new set of rules is starting to emerge. The shadow Chancellor George Osborne made an important start last week, questioning the relationship between the Bank of England and the Financial Services Authority, and the size and role of the banks.
But the debate is going to have to go a lot further, and the policies put forward will need to be a lot more radical, if the hard work of putting the UK economy back together again is to start.
Let's start with what went wrong. In truth, just about everything. Brown mis-understood the way the City needs to be regulated. He put too much faith in inflation-targeting. He allowed the banking system to run out of control. And he mis-managed public finances. The results are plain for everyone to see -- the worst financial crisis of the major developed economies, and probably the longest and most painful recession as well.
By now, just about everyone outside of the Ten Downing Street bunker accepts that the system needs to change. But how? Here are four places we should be making a start.
One: The Monetary Policy Committee, created by Brown in 1997, needs to start targeting asset prices along with conventional measures of inflation. In retrospect, it clearly made a mistake in allowing house prices to run out of control. True, Mervyn King, the Governor of the Bank of England, issued plenty of warnings. The alarm was sounded. But, looking back, through 2004 and 2005 the MPC should have been steadily raising interest rates to whatever level was necessary to get house price inflation back to zero. Sure, it would have been painful - but not nearly as painful as what we are experiencing now.
We need to learn the lessons of that. As well as targeting retail prices, the MPC has to be told to target asset prices. If not, we are simply doomed to repeat the same mistakes.
Two: The Financial Services Authority has clearly failed. A zealously bureaucratic organisation, it focussed relentless on petty rules rather than the big picture. So, for example, it made it virtually impossible to open a bank account without producing birth certificates (in triplicate) for ancestors stretching back to 1700. But if you wanted to bankrupt the whole country, that was fine.
In reality, splitting out financial supervision from the central bank was a bad decision. In a crisis, they are the same thing. The central bank can't stand by and watch a major bank collapse – as we discovered last autumn. But if it has responsibility, it should have power as well. The Bank of England should be handed back the final say over the regulation of the banking system. The small, petty rules should be ripped up, and the replaced with broad principles designed to protect the system as a whole. Banks are full of clever, hard-working people thinking of new ways to blow up the system – only a regulator very close to the pulse of the market can be fast and flexible enough spot problems early enough to tackle them. The Bank of England is the only body that can do that.
Three: A clear strategy for the nationalised banking system should be set out. We don’t want to create the British Leyland of financial services, offering up the Morris Marina of accounts, and the Austin Princess of investments. The small, state controlled former building societies such as Northern Rock should re-mutualize: as soon as they are in decent enough shape, they should be handed back to their account holders (which would be a great way of increasing deposits as well – it would be carpet-bagging in reverse). After all, the mutual have done well so why not create more of them?
The two big state-controlled banks – Lloyds HBOS and Royal Bank of Scotland –
should be split up: Lloyds back into Lloyds and HBOS and RBS into RBS and NatWest. By themselves, NatWest and Lloyds would do fine. HBOS could be re-mutualized as soon as possible, and RBS left to whither, as a warning to other banks that get too ambitious. The important task is to create an open and competitive banking system as soon as possible – not one dominated by two nationalised giants.
Four: Public spending has to be bought under control. The ‘golden rule’ that Brown created in 1997 to keep debt under control is a joke. A rule isn’t a rule when you change it every time it looks likely to be breached. The rule that Britain needs is that public spending should be capped at a maximum of 40% of GDP over an economic cycle (which means it shouldn’t be any higher than 35% at the peak of a boom). All the evidence shows that once the state sector climbs above 40%, economic performance declines dramatically. The cuts needed to achieve that might be painful – but are surely preferable to years of French-style stagnation.
No doubt there will be plenty of other reforms needed as well. But a new inflation target, a re-regulated City, and slimmer, privatised banking system, and a shrinking public sector would give the UK economy at least the chance of relatively quick recovery.